Canada: When You Ought To Have Known: Court Of Appeal Upholds Liability Against Successive Tippees Who Lacked Actual Knowledge Of The Source Of The Inside Information

In a decision released last
Thursday, January 25, 2018, the Ontario Court of Appeal considered
for the first time the definition of a "person in a special
relationship with an issuer" as it applies to successive
tippees who possess inside information. In Finkelstein v
Ontario Securities Commission, the Court of Appeal upheld
findings of liability and significant sanctions against Howard
Miller and Francis Cheng – the final two recipients in a
five-person long chain of successive tippees – even though
neither Miller nor Cheng knew that the source of the information
was an insider. According to the Court of Appeal, however, they
ought to have known that they were acting on inside
information.

Background: The Finkelstein decision
arises from the flow of material, non-public information about a
reporting issuer – Masonite International Corporation
("Masonite") – through a chain of
five people. The information originated from a Bay street mergers
and acquisitions lawyer, and was passed through two other
individuals before it was received by Miller, who then passed it on
to Cheng (both of whom were investment advisors at the same
firm).

Subsections 76(1) and (2) of Ontario's Securities Act
contain prohibitions against the trading on, or the tipping of,
undisclosed materials facts or changes concerning an issuer by
persons or companies in a "special relationship" with the
issuer. Subsection 76(5)(e) defines a "person or company in a
special relationship with an issuer" to include a person or
company who receives insider information and "knows or ought
reasonably to have known that" the source of the insider
information is a person or company in a special relationship with
the issuer.

In a 2015 "Merits Decision" , an
Ontario Securities Commission ("OSC")
panel found that all five individuals were in a special
relationship with Masonite and had therefore breached the insider
and tipping provisions and acted contrary to the public interest.
The Divisional Court dismissed the appeals of all
but Cheng, setting aside the findings of liability against Cheng
because of errors in the OSC's analysis of the evidence. The
Court of Appeal granted leave to appeal to Miller and the OSC in
respect of Cheng, but denied leave to the others.

The Court of Appeal Decision: At its heart, the
appeal concerned the interpretation and application of section
76(5)(e) of the Securities Act and whether Miller and
Cheng "ought reasonably to have known" that their
respective tippers stood in a special relationship with Masonite:
there was no dispute that Miller and Cheng received material,
non-public information about Masonite, nor that neither of them had
actual knowledge that the source of the information was a person in
a special relationship with Masonite.

The Court of Appeal ultimately rejected Miller's appeal and
granted the OSC's appeal in respect of Cheng, restoring the OSC
panel's decision. Under subsection 76(5)(e), the tippee does
not necessarily need to know the identity of the initial tipper,
and, on the facts of this case (including the application of the
below factors), both Miller and Cheng ought to have known that
their respective tippers were in a special relationship with
Masonite.

When You Ought to Have Known: The statutory
provision of "ought reasonably to have known" requires an
objective test: should a person standing in the shoes of the
tippee, reasonably assume that the information passed to her
originated with an insider?

The bulk of the evidence in insider trading and tipping cases is
usually comprised of circumstantial evidence of the tippee's
knowledge of the source of information. The Court of Appeal
therefore held that it was reasonable for the OSC to identify
certain factors to assist in drawing permissible inferences as to
whether it was more likely that not that insider trading and
tipping had occurred. The following factors, while not exhaustive,
serve as a "reasonable guideline that can be applied in the
vast majority of situations" when considered in light of
totality of the evidence:

What is the relationship between the
tipper and tippee?

What is the professional
qualification and standing of the tipper? Does the tipper have a
position which puts him in a milieu where transactions are
discussed?

What is the professional
qualification of the tippee? Does her profession or position put
her in a position to know she cannot take advantage of confidential
information and therefore a higher standard of alertness is
expected of her than from a member of the general public?

How detailed and specific is the
information? The more detailed and specific the information, the
less likely it could result from a rumour.

How long after he receives the
information does he trade? A shorter period of time may give rise
to the inference that the information is more likely to have
originated from an insider.

What intermediate steps before
trading does the tippee take, if any, to verify the information
received? The absence of any independent verification may suggest a
belief on the part of the tippee that the information originated
with a knowledgeable person?

Has the tippee ever owned the
particular stock before?

Was the trade a significant one given
the size of his portfolio?

The Takeaway: The Finkelstein decision
is a stark reminder that you don't need to actually know that
you are acting on information received from a company insider to be
liable for insider tipping or trading. Recipients of non-public
information may face significant sanctions, even where the source
of the information is unclear or unknown to the tippee: in Miller
and Cheng's cases, such sanctions include monetary penalties
totalling about $525,000 and $225,000 respectively, as well as a
ten-year ban on trading (with carve-outs), registration, and acting
as directors or officers of a reporting issuer. Individuals who
receive non-public information about a company should seek legal
advice before trading on that information or sharing it with
others.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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